This paper studies the allocation of skilled and unskilled workers with different
human capital levels between two locations: city and rural area. In the
city activities are congregated thus there is externality in production. In rural
area production is spread out and no externality exists. Given a distribution
of workers with various human capital levels in an economy, the social optimal
allocation gathers workers with higher human capital in each category in the
city, which all competitive equilibria fail to achieve. As a result, any policies
that keep workers with low human capital out of the city increase total output.
We further demonstrate that in some cases it is necessary to impose direct
and selective barrier on the rural-urban migration. However, such policy maintains
the city premium for unskilled labor. Great incentives exist for illegal
rural-urban labor ‡ow.